Welcome to McKesson Corporation’s fiscal 2010 third quarter conference call. (Operator Instructions) I would now like to introduce Miss Anna Schrenk – Vice President Investor Relations.
Good afternoon and welcome to the McKesson fiscal 2010 third quarter earnings call. With me today are John Hammergren, McKesson’s Chairman and CEO and Jeff Campbell, our CFO. John will first provide a business update and will then introduce Jeff who will review the financial results for the quarter. After Jeff’s comments we will open the call for your questions. We plan to end the call promptly after one hour at 6:00 pm ET.
Before we begin, I remind listeners that during the course of this call we will make forward-looking statements within the meaning of the Federal Securities laws. These forward-looking statements involve risks and uncertainties regarding the operations and future results. In addition to the company’s periodic and annual reports filed with the Securities and Exchange Commission, please refer to the text of our press release for a discussion of the risks associated with such forward-looking statements. Thanks, and here’s John Hammergren.
Thanks Anna and thanks everyone for joining us on our call. I’m pleased with the solid execution and continued momentum in our business. For the third quarter we achieved total company revenues of $28.3 billion and net income of $326 million or $1.19 per diluted share.
Considering the challenges we faced coming into the year, we have performed better than we had anticipated and I’m proud of what we’ve accomplished so far. Some of our excess was one time in nature such as the benefit from the Securities Litigation settlement proceeds distributed to our 401K plan.
But our strong performance also stems from operational excellence, diligent cost management and being ideally situated to benefit from opportunities such as the increased demand related to this year’s flu season.
Let me take a moment to talk about the flu season now since it impacts several different areas of the company. In the third quarter we experienced a positive impact from higher demand for flu related products across several of our businesses. Certainly the single largest contribution has come from our expanded relationship with the Centers for Disease Control and Prevention to handle the centralized delivery of the H1N1 flu vaccine and ancillary medical supplies.
On our last conference call in October, there was some uncertainty because it was difficult to predict how many doses of the vaccine would ultimately be delivered and because we had not finalized the necessary modifications to our existing agreement with the CDC to encompass this program.
Since then we finalized the agreement and have managed well in excess of 100 million of the vaccine and ancillary supplies and have done so in a safe and efficient manner.
In addition to delivery of the vaccine, we experienced increased demand for flu related medications that are distributed through our U.S. pharmaceutical business; food test kits and other supplies that are shipped through Medical Surgical and calls to our Nurse Hotline that are part of our Health Solutions business.
Typically, flu related demand is relatively stable from year to year. This year, we had a significant increase in demand due to the H1N1 virus and it was heavily weighted to the December quarter.
Moving on to some specifics for the third quarter, Distribution Solutions performed well with solid contributions from all of our businesses. Revenue growth of 4% was in line with our expectations given the continued impact from the loss of two customer buying groups in U.S. pharmaceutical in late fiscal 2009. These customer losses will impact us for the remainder of our fiscal year.
The other dynamic in U.S. pharmaceutical is that our sell side margin is down as a result of events that we experienced the last fiscal year. Consistent with comments that we made in the fourth quarter last year, it will take us a full year to lap the impact.
Our Generics programs continue to lead the market. While one stop sales are still impacted by last year’s loss of an independent buying group customer, the team was able to grow Generic gross profit in the quarter with continued focus on better compliance within our existing customer base.
Included in our U.S. pharmaceutical distribution and services results are the results of our Specialty Care Solutions business. This business is performing well, benefiting from both its long standing relationship with the CDC and the launch of a generic last quarter.
Turning to our businesses in Distribution Solutions, our Medical Surgical business had a solid contribution to the overall success of Distribution Solutions. Medical Surgical’s revenues grew significantly reflecting increased demand related to flu and aided by acquisitions made in late fiscal 2009.
Aside from the strength of the flu, the business has demonstrated solid execution. I’m pleased with our progress in Medical Surgical, particularly the continued focus on expense control measures and global sourcing of McKesson branded products.
Lastly, we had a very strong performance in our Canadian distribution business with revenues on a constant currency basis up 8%. During the quarter we sold our 50% equity interest in McKesson Logistic Solutions. We had started this third party logistics business organically in 1994 and merged it with a company named ALS in 2004 to form a 50/50 joint venture which grew to 55 manufacturing customers by the time it was sold.
Although successful, it was not core to our Canadian distribution business so we took the opportunity to monetize our investment when we were able to ensure the realization of a nice profit.
We remain excited about our business in Canada. Many of our programs and solutions that are available to our U.S. pharmaceutical customers are also available in Canada which clearly differentiates the value of our offering.
While we’re best known as a leader in pharmaceutical distribution, McKesson Canada does more than order fulfillment and logistics. We’ve automated 2500 retail pharmacies and every year over 100 million doses are dispensed through McKesson’s hospital automation solutions. The strength of our distribution customer relationships has provided a great platform for the growth of our technology footprint in Canada.
Recently we signed a contract with the Province of Quebec to install our PAX technology in 43 hospitals and we are connecting a network of 95 sites that will be sharing medical images. In addition, our PAX business has secured contracts for the largest clinical organization in the country, Canadian Medical Laboratories, serving 120 ambulatory radiology clinics across Canada with additional interest in U.S. clinics.
I’m extremely pleased with our year to date performance in Distribution Solutions. We have achieved strong results despite the challenges we faced coming into the year and we expect our momentum to continue.
Turning now to Technology Solutions, in the third quarter our performance was steady with top line growth driven by services revenues. Over time we’ve built a stable business with stable business models throughout the Technology Solutions segment.
Much of our revenue comes from predictable recurring streams. We believe the steady nature and complete solution set of out technology businesses fit well within the larger McKesson offering.
The stimulus package created the incentive for health care providers to improve care by implementing clinical technology solutions such as the electronic health record. Last month, the Federal Government released proposed and interim final rules that health care providers and vendors will need to meet under the High Tech Act portion of the American Recovery and Reinvestment Act.
We’ve working closely with OMC’s Federal Advisory Committees both the HIT Policy Committee and the HIT Standards Committee over the past eight months so there really were no surprises for us in the receipt of the proposed rules.
The proposed criteria for meaningful use and certification both of which are necessary requirements to quality for stimulus monies are generally comparable with the objective previously published as recommended by the Committees and our electronic health records systems for hospitals and physicians are well positioned to meet these objectives.
The official certification process has not been fully delineated so no technology company has had their products certified, but we are on track to submit our EHR products for initial certification as soon as we have a clear indication of the process. We are eager to see the process finalized so that we can continue to move our customers through the deployment process.
We’ve just announced a strategic partnership with HP to accelerate electronic health record adoption at independent physician practices across the country. McKesson and HP will offer physicians McKesson’s EGR practice management systems bundled with HP office hardware and preconfigured for easy installation.
The two companies are working together toward the common goal of simplifying physician EHR adoption so physicians can meet the stimulus deadlines. We expect our technology business will benefit from the clinical wave that has been created by the stimulus and we can also provide the connectivity features that allow rapid movement of clinical and financial information through the entire network of health care.
Not only are we helping customers serve their near term clinical requirements, we will have ongoing opportunities when hospitals turn to us to help them re-architect their financial systems to provide improved cash flow and connectivity and improve relationships with patients.
We’ll be able to accomplish this with solutions such as Horizon Enterprise Revenue Management which is the complete reinvention of the financial tools that hospitals use to manage the financial and administrative side of the enterprise combined with the technology necessary to connect with payers and patients.
We mentioned this last quarter but it’s important to emphasis that Horizon ERM was designed with an architecture similar to our clinical systems and therefore the integration and inner workings of these two solutions are compatible, and the system incorporates other McKesson software solutions such as clinical content and relay health connectivity tools.
None of our competitors has an offering that services the entire health care system the way that McKesson does. Our ability to understand the interactions that take place in this fragmented health care system and creates solutions from that knowledge benefits our customers and provides opportunity for us.
Increasingly, our connectivity solutions through relay health and our solutions for the payer market through our health solutions business are becoming larger components of technology solutions.
In McKesson Health Solutions, our footprint is unparalled and we uniquely combine expert technology with evidence based clinical information to enable payers to manage their administrative and medical costs.
In our Relay Health business we facilitate the exchange of information among almost every player in the health care system including health systems, pharmacies, payers, physicians, government agencies and consumers.
We have expanded our health information exchange footprint with strategic wins at health systems that are choosing Relay Health to exchange health information among various constituents. With more than one million patients involved in our system, McKesson is the only major player that has the patient actively participating in HIE connectivity.
Relay Health is playing a significant role in helping customers achieve meaningful use by supporting inter-operateability and data exchange requirements for hospitals and physician practices using both McKesson and non McKesson solutions.
I’m pleased with the work that has been done by the team to help our customers identify the information technology they need to design adoption roadmaps to help them reach their objectives for meaningful use.
Year to date our Technology Solutions results are tracking with what we expected as we entered the year with steady revenue growth and solid operating margin expansion. Our customers are buying and installing clinical solutions and we are ramping up our business to match the momentum created by the stimulus.
Our intention is to invest more heavily in the back half of this fiscal year because we are committed to successful implementing our customer’s clinical solutions, but we are also building the business for the next decade which is why our offering includes the latest financial solutions for hospitals that I discussed previously as well as the connectivity that will be necessary to exchange information throughout the network.
Now before I turn it over to Jeff I want to leave you with a few more general thoughts. This really is a very fortunate time to be in health care, and I believe McKesson is perfectly positioned.
Everything we see in our future is generally supportive of continued growth in our businesses. We are ideally situated in an environment where the use of pharmaceuticals are doing nothing but expand given the aging population and the evidence and proof that pharmaceuticals are the lowest cost alternative from a health care perspective.
Our diversified technology platform is at the center of much of what is going on in health care today; the current clinical wave, the growing focus on connectivity and the enterprise wide financial systems that will be required to pull it all together.
All of our businesses are producing sound operating results with very positive cash flow. We have demonstrated our ability to deploy cash with a portfolio approach that over time has created significant value for our shareholders.
Over the past seven fiscal years we’ve deployed more than $4 billion for 33 acquisitions which have paid off with strategic value for the company and good financial results. Over that same time period we’ve deployed more than $4 billion to repurchase 83 million shares and doubled our dividend.
You might find us building cash at times but I would remind you that our capital deployment is balance when you view it over years as opposed to quarters. We do not manage decisions around share repurchases, acquisitions and the dividend on a quarter to quarter basis.
Instead, we are patient and take a longer term view with the intent of consistently exceeding our shareholders expectations toward the use of our cash flow.
In summary, I’m confident in the earnings potential of the company and pleased that we are raising our full year guidance and now expect earnings per diluted share of $4.55 to $4.70 for fiscal 2010 excluding the favorable second quarter litigation credit.
With that, I’ll turn the call over to Jeff and return to address your questions when he finishes.
Thanks John and good afternoon everyone. As you’ve just heard, McKesson is built upon the momentum achieved in the first half of our fiscal year to deliver solid third quarter results. Before I begin reviewing our financial performance, let me point out that my discussion will exclude for comparison purposes the impact of the prior year’s third quarter AWUP litigation charge.
As usual, I’ll begin by discussing our consolidated results then I’ll provide additional color when I discuss each segment in more detail and I’ll close with an update on our full year outlook.
Revenues for the quarter were $28.3 billion representing 4% growth. Gross profit for the quarter increased 8% to $1.5 billion. This leverage at the gross profit line is driven by Distribution Solutions.
Total operating expenses for the quarter increased 5% to $946 million due to higher employee compensation costs, foreign exchange rate movements and higher legal expenses and legal settlement charges.
While we continue to see some benefit from the cost containment initiatives we put in place beginning mid fiscal 2009, we have begun to lap these efforts. Operating income for the quarter grew 16% to $509 million.
Moving below operating income, other income was $25 million compared to $17 million in the prior year. As discussed in our October earnings call, the current year benefited from the sale of our equity interest in McKesson Logistic Solutions which resulted in a pre tax gain of $17 million or approximately $0.05 per diluted share.
Excluding the impact of this sale, the decline in other income was primarily due to lower interest income resulting from lower prevailing interest rates.
Interest expense for the quarter of $47 million increased due to the $700 million in debt we issued last February.
Moving to taxes, our full year run rate remains at the 32% we have been using all year. Our third quarter effective tax rate of 33.1% includes a $0.03 impact from unfavorable tax discrete items. This compares to 31.2% in the prior year as the prior year included $0.03 of favorable tax discrete items.
Net income was $326 million and diluted earnings per share was $1.19. To wrap up our consolidated results, this year’s EPS number was aided by the cumulative impact of our share repurchases which lowered our diluted weighted average shares outstanding by 1% year over year to 274 million shares.
Let’s now move on to Distribution Solutions results. In this segment we are pleased with overall revenue growth of 4% compared to the same quarter last year. Total U.S. pharmaceutical distribution and services revenue increased 2% primarily reflecting market growth, partially offset by the fiscal 2009 customer losses that we previously discussed.
As you’ve seen for several quarters now we continue to show a shift from warehouse purchases to direct store delivery by a large customer. This was substantially completed this quarter.
Canadian revenues on a constant currency basis grew 8% for the quarter primarily due to market growth. Including a favorable currency impact of 15% Canadian revenues grew 23% for the quarter. Medical Surgical Distribution revenues were up 11% for the quarter to $758 million.
Gross profit for the segment grew 12% to $1.1 billion up from $1 billion a year ago. The increased demand related to the flu season which I’ll come back to in a few minutes and to a lesser extent increased margins from the sale of generic drugs helped drive an improved mix of higher margin products across our distribution businesses.
These events drove a significantly expanded gross profit margin rate. Partially offsetting these benefits, our sell margin was negatively impacted by customer renewals and the loss of customers that occurred late in our fiscal 2009 as well as lower compensation from branded pharmaceutical manufacturers due to timing.
Our Distribution Solutions operating expenses increased to 2% for the quarter to $568 million which is below the 4% increase in revenues, highlighting our continued ability to achieve expense leverage in this business.
Operating profit for the quarter was $558 million compared to $439 million in the prior year. As I mentioned earlier, the current year benefited from the sale of our equity interest in McKesson Logistics Solutions.
In summary, and before I move on to Technology Solutions, we’re very pleased with all the efforts of our Distribution Solutions team to mitigate the challenges we faced at the beginning of this fiscal year.
In Technology Solutions, total revenues grew 3% for the quarter to $771 million. This brings year to date growth for Technology Solutions to 2% which is roughly in line with our full year assumption to remain at levels similar to fiscal 2009.
Services revenues increased 6% in the quarter to $610 million reflecting the more stable nature of these service revenues. Assistance revenues of $138 million declined 2% from the prior year. Hardware revenues of $23 million in the quarter were down 32% from the prior year, reflecting lower rates at which hardware is attached as part of system implementations and overall reduced hardware component costs.
Technology Solutions gross profit declined by 1% to $351 million driven primarily by a higher software deferral rate, an additional amortization in costs related to Horizon enterprise revenue management. When Horizon generally became available in the second quarter it triggered incremental amortization expense of $75 million for the quarter.
Technology Solutions operation expenses increased 2% in the quarter to $271 million. These higher expenses are primarily due to the increased R&D spending and a weaker U.S. dollar compared to the prior year.
We continue to innovate and invest in R&D to maintain our leadership position. For the quarter Technology Solutions had total R&D spending of $104 million compared to $99 million in the prior year. Of these amounts, we capitalized just 14% compared to 19% a year ago.
Our operating profit in our Technology Solutions segment this quarter was $81 million, down 11% from the $91 million we recorded a year ago. Our operating margin in this segment was 10.51% for the quarter compared to 12.12% in the prior year.
We’ll leave our segment performance now and turn briefly to the balance sheet and our working capital metrics. Our receivables were $8.3 billion which is up from the December 21, 2008 balance of $7.6 billion. Our day sales outstanding remain flat at 23 days after adjusting the prior year for the $350 million utilization of our AR sales facility.
Moving on to inventories, through continued careful inventory management, and as a result of timing our 30 days sales in inventory again showed a nice improvement of three days compared to last year. Our inventories were $8.8 billion on December 31, a 6% decrease over the prior year.
For the second quarter in a row we have showed a modest sequential improvement for DSI from what we posted at the end of the previous quarters.
Our payables increased 6% to $13 billion from a year ago and day’s sales in payables increased to 44 days from 43 days last year.
These working capital improvements have resulted in $1.7 billion in operating cash flow year to date. These results include the impact of the $350 million AWP settlement payment that was released from escrow in our December quarter just ended. Based on our continued progress we feel very comfortable in our ability to generate in the range of $1.5 billion to $2 billion of operating cash for the full year fiscal 2010. This strong cash flow generation has led to a cash balance of $3.4 billion at December 31.
As our share repurchase activity has slowed during the year we now expect our full year average share count to come in a bit above the original guidance we provided of 272 million shares outstanding.
Our capital spending continues to trend as expected at $350 million to $400 million for the year.
Now I’ll turn to our outlook. As John mentioned earlier, we are raising our guidance on diluted EPS excluding the favorable second quarter litigation credit from $4.45 to $4.60 to a new range of $4.55 to $4.70.
As we’ve had a number of updates to our guidance range during the year, I think it’s worthwhile to review some of the key changes impacting our EPS range from the beginning of the fiscal year to now.
As a reminder, we started the year providing an EPS range of $3.90 to $4.05. Since then a couple of things have happened. First, we had a favorable legal settlement impacting the company’s 401K plan which drove approximately $0.15 of upside spread fairly evenly throughout the year.
Second, we had a $0.05 benefit related the third quarter sales of our 50% stake in the Canadian joint venture, McKesson Logistics Solutions. Third, we’ve seen increased demand from the flu that is incremental to last year’s flu performance.
We now expect the incremental demand for this flu season will contribute $0.35 to $0.40 to our full year EPS, a little more than two thirds of which came in our December quarter.
Looking to next year on the flu, our goal will be to find business opportunities that allow us to sustain this level of incremental profit but we are unlikely to sustain it all at this year’s level.
So, if you were to adjust for these three items the favorable 401K legal settlement, the McKesson Logistics Solutions sale and the incremental flu, you get to an EPS range that is $0.05 to $0.10 above our original guidance for the year.
In closing, we are pleased with our ability to rise to the challenges we have faced so far this year and we believe our solid execution to date will propel us to a strong finish in fiscal 2010.
Thanks, and with that, I’ll turn the call over to the operator for your questions. I would ask that you limit your questions to just one per person to allow others an opportunity to participate.
(Operator Instructions) Your first question comes from Glen Santangelo – Credit Suisse.
Glen Santangelo – Credit Suisse
Just a quick question on the health care IT business; basically in the press release you wrote that the gross margins were a little bit weaker as you’re seeing a higher software deferral rate. Can you just elaborate on that a little bit more? Is that basically just assuming that you’re seeing less demand in this environment or is that actually say something about revenue recognition and maybe these contracts taking longer to implement than you thought?
I think for the quarter the business probably experienced a little bit more of a change in the mix of the business than we normally would have seen that caused some of this but stepping it up just a level, I would say that our Technology Business has seen that our customers are buying at a rate that is at or above what our expectations were coming into the year.
The challenge for us now as we look at the rest of this year and into next year is the implementation time for some of these relationships that have expanded beyond what would have been perhaps a more let’s put this in as we go kind of philosophy to we want a contract for a complete solution to get ready for stimulus.
So what we might have normally installed in this quarter and recognized in this quarter from the software perspective and realizing to revenues, is not so much related to what we sell, what we book. It’s what will we recognize as revenue.
What we recognize as revenue is both mix related but also time to implementation and complexity related. So I think our tone and tenor of this should be positive albeit somewhat extended as it relates to getting actual P&L results from what our customers are asking us to do.
And you also saw similar related to the software, our comments about margins, are still in line with what we expected but we are investing as we suggested last quarter more heavily in the back half of this year which will continue through our fourth quarter and this is all in the spirit of how do we get these implementations done more quickly for our customers in time for the stimulus.
So it’s really a combination of more complex contracts and longer time to implement and then the added burden of expenses in advance of those implementations which you don’t see which are positive trends from the booking perspective.
Glen Santangelo – Credit Suisse
You said more complex contracts, does that mean that some of your clients are basically looking to push payments out as they can hopefully match up stimulus payments with the payments ultimately to the software vendor. Is that what you mean by that or no?
It’s certainly the characteristics of the contract as much as the complexity of the products they’re trying to buy all at one time so if we sold a simple product and got it installed, we recognize it in revenue and earnings. When we sell that simple product as part of a multi product contract, that revenue will get hung up until we get the entire contract installed.
So it’s actually a positive if you think about it in a multi quarter sense. It just might be a negative if you think about it in a short term sense.
Your next question comes from Charles Boorady – Citi.
Charles Boorady – Citi
My question is going to be on the Rite Aid renewal and congratulations on that. I know you don’t talk about customer specifics but I’m curious on just seasonality of earnings how that might be impacted by this renewal and also take outs generally, were there changes in the nature of the relationship or changes in the contract. I know for some contracts year one takes a step down before rebounding in subsequent years.
Well we’re obviously like you pleased that we renewed our valued relationship. It’s a long standing relationship and we’ve developed a significant partnership with Rite Aid and it relies on great integration on both sides of the relationship to deliver great value for both of us.
I think the way to describe the Rite Aid renewal is that any of these large customers you have to step up and deliver value and you can’t charge more than the value you’re delivering and we’re fortunate to continue to prove to Rite Aid and to others that we’re the partner of choice for these relationships and I think if there had been any material changes to this relationship we would have probably said something specific about it.
I think that this falls in line with that sort of annual process that we have or every third year process we have with customers that we go through from a renewal perspective and there’s really nothing abnormal or unusual in this environment.
Charles Boorady – Citi
So no change to the seasonality of the quarterly earnings we should expect related to the renewal?
No, the seasonality in our earnings are more driven by the way our relationship with manufacturers drives the margin structure in our P&L. So if you actually look at the quarter break down and the margin rates, you’ll see some variability. That seasonality might be a little bit related to the cold and flu season but it’s more related to the behavior of manufacturers relative to price increases and the continued structures structure of our relationships with manufacturers where we receive payment in those kinds of interval.
So albeit we try to move our margins up year over year, in our Distribution Solutions segment margin rate increases and we expect to experience that again this year as we guided to at the beginning of the year, we will still see seasonality in our business, and that is a completely different discussion than customer contract renewals.
And I don’t thing there’s seasonality in that context of customer renewals. If you lose one by surprise or something negative happens, it just happened and it has nothing to do with how our season and our quarters work.
Your next question comes from Robert Willoughby – Bank of America.
Robert Willoughby – Bank of America
I guess I look at your portfolio approach to managing capital and hear a comment on creating value but on our numbers Here you’re trading on a discount to the group and the biggest difference would be you’re heavier on acquisition and lighter on dividends. Any thought to revisiting that strategy? What are we basing our enthusiasm for deals on Here?
I would say that our valuation is probably affected by the fact that we have $3.5 billion or whatever on our balance sheet that hasn’t been deployed in either direction and if you actually go back and look at the history of our acquisitions, I believe we’ve been able to deliver more value to our shareholders through well executed acquisitions than we have in share repurchases or dividends.
That’s not to say that we don’t pass on many deals because dividends and share repurchases are a better decision. So our confidence in doing acquisitions is built on the success we’ve had with them. Our confidence on buying shares or paying dividends is the fact that we appreciate that we have a portfolio approach and sometimes the capital is better deployed in that way.
I guess the message in this quarter is that we don’t feel necessarily a big rush to deploy the capital and I’m hoping that our shareholders will continue to look at that cash on our balance sheet as a point of value as opposed to a missed opportunity to create value.
Robert Willoughby – Bank of America
I guess it’s a point of value though would I describe a premium on an ability to get it deployed more rapidly and without any loss of efficacy I guess is the question.
Well clearly it is a drag on our near term results if its not deployed in a way that produces returns that are at or superior to the returns we get on the rest of our capital. So I think we have an awareness of the fact that we are not optimized from a capital structure at this moment, but as Jeff and I mentioned in our prepared comments, we try to look at these things over a longer horizon that just a quarter or two or even a year for that matter.
And hopefully, the time that we spend waiting for the right deployment opportunity is made up for by the right deployment ultimately and I think we’ve taken a successful portfolio approach to doing that over the last seven to ten years and we’ll continue to.
Your next question comes from Ross Mukin – Deutsche Bank.
Ross Mukin – Deutsche Bank
Just a follow up on Bob’s question. It came up this morning as well on one of your peer’s calls. It seems like there’s quite a bit of available assets in both the public and private market given some of the dislocation over the last 24 months in the financial markets. I was sort of thinking about places you’d focus on deploying that capital potentially from an M&A perspective. Can you point to a few areas that consistently places where you are looking to put investments to work?
I think we’ll continue to use the portfolio approach so I don’t want to have people misinterpret my comments and assume that we’re only going to do acquisitions. But speaking specifically about acquisitions, we think there are opportunities and they appear sometimes not when you want them to but there will be opportunities to deploy against acquisitions in all of our core businesses and we’ve done it in pharmaceutical and medical distribution in the past and in technology.
There are clearly times where things get over valued and there are times when assets are not for sale that you have to be patient about, but I think the most important take away from this discussion should be that we’ve built a track record and if we choose to deploy any of our capital in acquisitions I would hope to do so intelligently and in a way that creates more value than a share repurchase would create for us.
So I think you’d find that we would look to the businesses that we’re in today and we bring some knowledge. We bring some synergy. It’s unlikely that we will buy companies that our shareholders could buy and we can’t add any value beyond what you could add to them to hold them independently.
Ross Mukin – Deutsche Bank
That’s far more eloquent than I could have said it. One quick question on the gross margin for Distribution; there’s a lot of moving parts obviously there this quarter. We teased out the different contributors to some of the strong year over year growth and whether we look at it in terms of general compliance going up or at risk launch or new generics, versus some of the headwinds you have from lost business, how do we think about that in terms of the percent components and maybe from a qualitative perspective?
If you’ll bear with me for one second, let me answer starting at the operating margin for Distribution then I’ll come back to the gross margin.
Of course we always have quarterly volatility so you know we encourage people to think about the margin on a full basis. But if you look at the operating margin for the December quarter, if you take out the year over year change in the flu profits, the operating profit margin is relatively flat and that’s because of a change this year in the timing of some of our compensation from the branded manufacturers.
If you look at the full year though, for our FY10 versus FY ’09 our expectation is if you strip out in both year flu profits you would see a basis of at least a 10 basis point improvement year over year in the operating margin rate for Distribution Solutions.
Now to come to your gross margin comment; it gets a little bit more judgmental at the way we adjust at the gross margin level for the flu but you’d see a pretty similar pattern. So for the December quarter your gross margin would be down a little bit but for the full year your gross margin is going to be up and once you strip the flu out, the overwhelming driver of that year over year gross margin improvement are the improved profits on generics.
Because of the loss of the retail independents we experienced last year the real driver of the increased profits on generics this year comes from a combination of better compliance, better penetration amongst our existing customer base, better sourcing combined with a pretty good launch schedule this year although I would point out that this year’s launch schedule is not quite as good as last year’s.
Your next question comes from Lawrence Marsh – Barclays Capital.
Lawrence Marsh – Barclays Capital
If I could just elaborate a little bit I think Jeff one of your comments was reflecting on the incremental contribution from flu. I think you said $0.35 to $0.40 this year and I think that compares to roughly $0.20 you said after the September quarter. I wanted to understand that and also I think you said if you back out all the adjustments for this year you’re $0.05 to $0.10 above your original guidance which I think was $3.90 to $4.05. Could you reconcile that with thinking ahead your goal was to find business opportunities to match the $0.35 to $0.40 contribution from flu but I think you said it would be tough to fully match that so if you would elaborate on that that would be great.
Let me start with what’s changed on our view of the flu now versus 90 days ago and then I’ll talk a little bit about our goal of recreating next year as much as we can of this year’s incremental profits from the flu.
90 days ago when we had our last earnings call, it was still very early on in the flu season and in fact as you recall in our September quarter our profits year over year related to the flu were pretty flat, so we were just entering the period of getting a sense of what kind of incremental demand we were going to see for everything from generic drugs related to the flu to flu test kits in our medical surgical business, the seasonal flu vaccines and then of course at that point had not finalized our contract for the amendment to our existing contract with the CDC and there was tremendous uncertainty I think it’s fair to say 90 days ago about just exactly how the Federal governments efforts to deliver H1N1 vaccines across the country would play out.
So 90 days later, we not only finalized that CDC contract but we have a very clear grasp now of likely shipment volumes. We think that we’ve been through the peak of things like demand for flu test kits although I suppose we could be surprised in the next 60 days.
So it’s a combination of all those things that has taken us from what was a very rough estimate 90 days ago to today when I think it’s a pretty strong read on the incremental benefit this year from all of those things we do related to the flu versus last year.
So that is a long way of answering your question how we got from up to $0.20 which is what we said 90 days ago all the way up to a range of $0.35 to $0.40 now.
I think as we came into this year we were obviously very focused on what are we going to do with the loss of the $3 billion of revenue at the first day of our new fiscal year and so we put in several majors to try to counteract that and clearly tight expense controls and optimizing our performance with our existing customers and suppliers to improve returns on those pieces of business and basically looking everywhere for opportunities.
And clearly we were well positioned I think to take advantage of the opportunity presented with the flu season. We were in very good businesses that participate in flu but we also had a business that had a current tract record of performance with CDC and we were able to build out those six distribution centers in a matter of weeks to service this unprecedented requirement.
So clearly I’m pleased with what we did this year to fill the hole. I would hope that as we come back and we start fiscal 11, we don’t have a similar kind of customer hole to dig our way out of as we start the year that will give us the typical momentum that you expect from McKesson year on year.
And then secondly, to Jeff’s comments and my comments relative to trying to find additional opportunities to help cover the year on year lap of the flu event, it’s still not clear to us what demands might be on us next year, what kind of flu season we might have. There’s discussion about H1N1 coming back in a more virulent way and clearly I think we’ve demonstrated our ability to help in these emergency needs of the country and hope that the six facilities that we’ve established will not all be turned off and set aside.
Clearly anything we can do to work through that with the CDC or others in terms of utilizing those assets will be nothing but upside given that we had anticipated that they would be put out of commission as the season draws to an end.
So there would be an opportunity dependant on your view of what might happen in the future for the vaccination perspective and how our vaccine business overall might continue to evolve given our import now to the country relative to things like standard flu and other vaccinations that take place like we started with with the Children’s Health Vaccine program.
So I think the point of our discussion is to highlight the fact that the $0.35 to $0.40 we believe is unusual and also highlight the fact that we are working hard to find other opportunities that will help us cover some of that year on year comparison.
Lawrence Marsh – Barclays Capital
But just to be clear, it sounds like you’re saying that vaccine and other relationships with CDC you’d be able to offset some of that $0.35 to $0.40 next fiscal year. You’re saying it may not, you’re obviously tough to fill the entire hole, but you could fill with some confidence a good bit of that with existing relationships around flu apart from the acquisitions and other things?
I think it’s difficult for us to talk about fiscal 11 on this call given that we’re still working through the numbers and what that might be and we’ve got one quarter left to go. I think the message you should be hearing from us is we executed this relationship with the CDC in a flawless way and we furthered our relationship and our credential on our ability to do this going forward.
I can’t speak for the Federal government or the medical community in terms of what desires they might have for this kind of a program. What I can say though is that vaccines are used in many ways in this country and there might be other ways we can assist the distribution of specialty products like vaccines that are highly regulated and need to be refrigerated etc. through this distribution capability.
But even if you set all that aside, you should assume that our teams are working as they think about next year not only how do we grow off of the $3.90 to full $0.05 to $0.10 that you were talking about but also what is that number really going to be as we focus on next year.
So as we finish the fourth quarter we’ll be prepared to give you better insight but I think what we attempted to do on this call was to quantify at least for everyone what we think the numbers are relative to the H1N1 activity this year and at least put out there one of the challenges we face as you think about next year.
Your next question comes from Gene Mannheimer – Auriga.
Gene Mannheimer – Auriga
My question relates to the tech solutions business in particular. As you worked with HIT policy and other standards committees over the last several months, do you feel that your Clinical Solutions today has the required level of functionality to meet the certification criteria relative to those of your competitors and if not, what level of investment and timing would be necessary to get there?
That’s a difficult question. I don’t really know where our competitors stand given that these final requirements have just now been published. What I can say is the reason I spent time on this on this call is that our team has not only been involved in helping to set the requirements, but we’re not surprised by them and I believe they believe that we have what it takes to get these products certified and through the process on behalf of our customers.
Saying it more frankly, I don’t know how we’d have a clinical business if it weren’t certified so I think it’s almost impossible to believe that we would not achieve certification. And if our competitors certainly can achieve certification, that’s what you’re looking at. We certainly can because there’s no technical reason that we see why that can’t happen.
As to the investment, we have made investment in our clinical products, quite significant investments over the last six to 12 months and we continue to make investments, but our heaviest investments right now are really focused on making sure that we can install these products in a time frame for our customers, and there’s a significant ramp in front of us with customers that might have been in a three year plan to install clinical’s that are saying I’d like to move that to 18 months.
As you might imagine that puts tremendous strain on our implementation teams and our customers to get ready for stimulus. So we are actually hiring out pretty aggressively because we have to train these people before they are deployed in a hospital and that expense if falling in this quarter and next quarter and we believe it will fall into next year as well as we start those implementations.
And as I mentioned in answer to an earlier question, part of our revenue and earnings outlook on this business is predicated on our ability to successfully deploy and install these products, not so much that our contractual obligations have changed with our customers but just from a percentage of completing accounting methodology perspective.
If we have a large contract which contains multiple products, our recognition of the entire contract is put off until the final product is installed. So if a customer is going to take 18 months to get a series of products or contracts installed, it will be the 18th month when we finally put the last product in when we will realize the earnings out of it even though we might have invested 18 months worth of expense to get that contract complete for that customer.
So I’m less concerned about our ability to get our products certified than I am about our customers to be ready for meaningful use based on the fact that at least 50% of the work that’s necessary is going to be done by them and their staff as opposed to what we try to do from the industry side.
There’s a lot of work to be done. But this is all good for us and it’s all going to deliver increased revenues and increased margins.
Your next question comes from Lisa Gill – J.P. Morgan.
Lisa Gill – J.P. Morgan
There’s still a pretty wide range as we go into the fourth quarter. Maybe you can just walk me through what the key drivers are on either side of your guidance range for the fourth quarter and secondly, it looks like depreciation and amortization went up quite a bit, much more than we expected. I’m wondering if that has to do with some of the investments on the IT side and therefore we’re seeing it through software development, if you could give us an update there.
Let me start with the Q4 question. I’d say really the biggest uncertainty that’s a little tricky to forecast is still the demand around the flu and so that’s probably the biggest thing that would either nudge us toward the higher end of our range or nudge towards the lower end of the range.
The second comment I would make is there’s always a little bit of volatility for the modest portion of our compensation from branded manufacturers that comes through price increases and while that’s modest it’s still enough to be noticed in a quarter.
Interestingly enough, year to date for our mix of products through 1231, price increases are down slightly though not by a material amount. Based on what we’ve seen so far in January I think we’ll be right in line with our guidance for the year of having price increased being pretty similar to last year. There’s always a little bit of uncertainty from that.
So those are probably the two biggest things I’d say at this point in time that could drive this up or down a little bit as we go through the March quarter.
As to your second question, the real biggest change on the depreciation and amortization side is that this quarter is the first quarter that we’ve begun to amortize the capitalized cost associated with our Horizon enterprise revenue management product, and so that was almost $8 million in the quarter. You’ll see now that $8 million every quarter for the few years which means that for half of this year and half of next year you’re going to see that as an increase.
But the rest of the year over year change in depreciation and amortization is really just the normal increase, I guess it’s another $12 million or so, the normal increase that comes from us spending $350 million to $400 million on various kinds of capital spending each year.
Lisa Gill – J.P. Morgan
I think that you mentioned that X flu you would expect for the entire year that operating margins would be up about 10 basis points in distribution, so if we look at how well you did in the first quarter and then X’ing out the flu going into the fourth quarter, it’s expected to be down year over year consistent with what our expectations are previously but can you remind us what the main driver there is? Is that the Pfizer contracts moving to fee for service or is it more the contract losses or the repricing of Rite Aid?
Let me back up and make sure I’m being clear. For the full year in Distribution Solutions, once you strip out the year over year impact of the flu, we’d expect our operating margin to be up at least 10 basis points for the year and a couple of moving pieces when you think about that are that we have a much more positive contribution from generics.
Our branded sell side margin is down because of the repricing and the loss of a couple of customers that we experienced last year. Our compensation from branded manufacturers is similar to up a tad year over year and then you’ve got some operating expense leverage.
So those are really the four components the two biggest of which are the upside from the generics and the headwind we’ve had all year from the customer repricings and losses we experienced late in our fiscal 2009.
Your next question comes from Charles Lee – Oppenheimer.
Charles Lee – Oppenheimer
Going back to the IT side in terms of meaningful use I understand that when you’re talking about trying to have all your solutions ready for certification, but as I read through the regulations, certification is currently one part of it and I think you alluded to the fact that providers have a lot of work to do. It seems like one of the areas that providers are struggling with is the reporting requirements and the all or none nature to it. It sounds like you’ve had a hand or at least a say in how these regulations were drafted. Can you talk about how in your conversations with CMS how they’re interpreting that and how maybe give a sense as this period goes on you might see some changes to those requirements.
I think it’s early and inappropriate for me to suggest or forecast changes to the requirements. I would say that my comments were primarily related to the industry’s requirements relative to IT suppliers to get health products certifiable. You are absolutely right that there’ a big requirement on the provider side in terms of what they have to do and frankly the providers are probably better positioned to speak for that and represent themselves in Washington.
However that said, we clearly are focused on helping our customers be more successful and we have been working to make all of these regulations slightly more lenient. For example, one of the earlier drafts required that every physician for every order use electronic orders, and that’s just not feasible. It’s not practical.
So things like that we’ve been able to change over time and I think we’ve been able to affect legislation. So I’m guardedly optimistic that through the comment period we’ll get some additional interpretation or perhaps a relaxation of some of this and that will help our hospital customers and physician customers get there successfully.
Charles Lee – Oppenheimer
On the flu, just to jump back to the question earlier, I know you didn’t want to talk about next year in great detail but you talked about some opportunities to try to replace some of that. Is this at least a conversation, obviously given your success in performance with CDC this year, have you at least had initial conversations with the government at least in broad terms or is that still a discussion to have at a later point?
I think we’re in constant discussion with all of our customers about their needs going forward and I think that it’s probably early to forecast what the government is likely to do in terms of vaccine for next year. But I do think that we’re well positioned should they choose to decide to have a centralized federally suggested vaccination program that we’re well positioned to assist with that.
But I do think it’s premature for us to suggest that the administration and legislators are likely to pursue that. I think things will unfold as we see this season wrap itself up.
Your next question comes from Thomas Gallucci – Lazard Capital.
Thomas Gallucci – Lazard Capital
I wanted to confirm one thing. I appreciate all the information about the flu as we’re trying to discern underling trends. First is the increase in the guidance driven by the bigger number that you’re expecting on the flu and you’ve given a lot of details to help us understand the underlying trend, can you give us a sense of what the flu has done on the top line for you this year?
Let me make sure I’ve got the questions right. I think question one was how the flu had impacted our guidance change versus 90 days ago and question two is a question on flu revenue.
So assuming that’s right, if you think about the $0.10 increase in our guidance I would really say that’s two things. It’s the fact that we’re $0.15 to $0.20 more optimistic on the flu than we were 90 days ago and that’s partially offset by the fact that we a little surprised this quarter by some legal costs we incurred most of which had to do frankly with some things related to the old HPLC acquisition and amazingly enough some things related to McKesson Chemical which I believe the company sold off in 1987. We’re still dealing with some of the environmental cases.
So those things along with some tax discrete items that went against us this quarter offset a little bit of that flu upside. That explains the guidance of where we were 90 days ago to today.
In terms of the flu impact on revenues, that’s actually a very good question because the impact on revenues is pretty immaterial to the company. Almost everything we do with regard to the flu is much higher margin from a flu test kit to a generic drug that’s flu related to importantly the CDC contract which is a third party logistics contract where we are not taking the value of the product into our inventory so of course a third party logistics contract always has a much higher margin than our normal distribution arrangement.
I want to thank all of you on the call for your time today. Let me conclude by saying that our thoughts and prayers go out to those affected by the crisis in Haiti and I certainly want to acknowledge the many McKesson employees who have offered their assistance whether through cash donations, donations of medical supplies and pharmaceuticals to the teams that are working overtime to fulfill orders for vaccines and medicines bound for Haiti. I really want to thank all of you for that contribution.
I’ll now hand the call over to Anna for a review of our upcoming events.
I have a preview of upcoming events for the financial community. On May 25 we’ll participate in the Oppenheimer Health Care Information technology one on one conference in New York. On March 1 we’ll host our traditional booth side briefing at the Annual Hems Meeting in Atlanta. We will release fourth quarter earnings results in early May. We look forward to seeing you at one of these upcoming events. Thank you and goodbye.
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